Entry of Foreign Banks in India and China: A Brief Note Kavaljit Singh

Implemented in conjunction with other macroeconomic policy reforms, financial liberalization remains one of the most controversial issues in economic literature. Financial liberalization is a process in which allocation of resources is determined by market forces rather than the state. It minimizes the role of the state in the financial sector by encouraging market forces to decide who gets and gives credit and at what price. Banking sector liberalization is an important component of financial liberalization. While making a strong case in favor of banking sector liberalization, its proponents claim that the entry of foreign banks in the poor and developing world is highly desirable and beneficial.1 But recent empirical evidence suggests that the entry of foreign banks could lead to misallocation of credit, which in turn could negatively affect economic growth prospects as bank credit is a vital input for investment and growth.2 Big foreign banks are not going to lend money to small and medium-sized enterprises (SMEs), small traders, informal sector and farmers. They tend to serve less risky businesses such as TNCs and big corporate groups. This has serious consequences for economic growth. In most countries, whether it is India, China, Japan, Germany or US, it is the SMEs (not big business) which are the backbone of economy. At present, the focus of the global banking industry appears to be on India and China, so it becomes important to analyze some of the recent developments taking place in these countries. Let us begin with India. Instead of liberalization pushing the opening of more bank branches in country, one finds that the trend is opposite. The total number of bank branches has declined, particularly in the rural areas (from 32939 in March 1997 to 32227 in 2004) in the post-liberalization period. More importantly, the Indian banking sector has witnessed a secular decline in rural credit. The rural credit went down from 15.7 per cent in 1992 to 11.8 per cent in 2002.4 So the entry of foreign banks has not led to increased rural credit. On the other hand, one finds that there is a growing interest among foreign banks to provide credit for non-essential items such as consumer goods. This situation could be gauged from the fact that car loans come cheaper than agricultural loans in India. In the post-liberalization period, one also finds that the lending to small and medium enterprises has declined from 15 per cent in 1991 to 11 per cent in 2003.5 SMEs are the

engines of Indias economic growth; together they contribute 40 per cent of Indias total production, 34 per cent of exports and are the second largest employer after agriculture.6 The growing neglect of bank lending to SMEs can have adverse implications on economic growth and employment. Foreign banks tend to follow exclusive banking by offering services to a small number of clients, instead of inclusive banking.10 Not only fo reign banks charge higher fees from customers for providing banking services but maintaining a bank account requires substantial financial resources. Take the case of Deutsch Bank which re-entered retail banking operations in seven cities of India in 2005. The Deutsche Bank opens bank accounts for those Indian citizens who could afford a minimum balance of Rs. 200000 (approx. US$5000) in their accounts with the bank. This is a princely sum by the Indian income standards which only affluent customers can afford it. The bias towards affluent customers is evident from the statement issued by Mr. Rainer Neske, a member of the Group Executive Committee of Deutsche Bank. At the launch of retail banking operations in India, Mr. Neske stated, As the leading retail banking provider in Germany and parts of Europe, we have keenly followed the developments in India - one of the most exciting growth markets in the world. The number of affluent Indian consumers is increasing, the market for consumer goods is expanding and private customers demand for excellent advisory services and high quality banking products continues to rise. is an exciting market that Deutsche Bank seeks to serve by providing advanced value, innovation and convenience to Indian customers. In this context, it is also important to stress here that much-touted microcredit programs launched by self-help groups and NGOs are no substitute for the formal banking system in India.13 With only 15 million clients (the second largest in the world after Bangladesh with 16 million), microcredit programs till date have only reached a fraction of under-banked population in India. Several studies have questioned the developmental impacts of microcredit programs as it has been found that their transaction costs are very high and often much of credit is used for consumption purposes rather than investment in productive activity. At best, microcredit programs can complement, not substitute, the formal banking system to meet the growing credit needs of farmers, rural entrepreneurs, small enterprises and informal sectors of Indian economy.

Major Recommendations by the 2nd Narasimham Committee on Banking Sector Reforms

In early 1997, Mr.Narasimham was again asked to chair another committee to review the progress based on the 1st Committee report and to suggest a new vision for Indian banking industry. In April, 1998, Narasimham Committee submitted its report and recommended some major changes in the financial sector. Many of these recommendations have been accepted and are under process of implementation. These recommendations can be broadly classified into following categories :(A) Strengthening Banking System (B) Asset Quality (C) Prudential Norms and Disclosure Requirements (D) Systems and Methods in Banks (E) Structural Issues (A) Strengthening Banking System RECOMMEDNATION PRESENT STATUS Capital adequacy requirements should take into account RBI has already implemented the same as market risks in addition to the credit risks market risks already taken into account for investment portfolio. In the next three years the entire portfolio of government More stringent norms under Basel II already securities should be marked to market and the schedule for implemented. the same announced at the earliest (since announced in the monetary and credit policy for the first half of 1998-99); government and other approved securities which are now subject to a zero risk weight, should have a 5 per cent weight for market risk. Risk weight on a government guaranteed advance should This has already been implemented by RBI. be the same as for other advances. This should be made prospective from the time the new prescription is put in place. Foreign exchange open credit limit risks should be More stringent norms under Basel II already integrated into the calculation of risk weighted assets and implemented.

should carry a 100 per cent risk weight Minimum capital to risk assets ratio (CRAR) be increased More stringent norms under Basel II already from the existing 8 per cent to 10 per cent; an intermediate implemented. minimum target of 9 per cent be achieved by 2000 and the ratio of 10 per cent by 2002; RBI to be empowered to raise this further for individual banks if the risk profile warrants such an increase. Individual banks' shortfalls in the CRAR be treated on the same line as adopted for reserve requirements, viz. uniformity across weak and strong banks. There should be penal provisions for banks that do not maintain CRAR. Public Sector Banks in a position to access the capital market at home or abroad be encouraged, as subscription to bank capital funds cannot be regarded as a priority claim on budgetary resources. Public sector banks are already accessing the capital market, e.g. PNB, Canara Bank, UCO Bank, Union Bank etc. have already successfully launched IPOs.

(B) Asset Quality An asset be classified as doubtful if it is in the NPA norms have been implemented substandard category for 18 months in the first instance and eventually for 12 months and loss if it has been identified but not written off. These norms should be regarded as the minimum and brought into force in a phased manner For evaluating the quality of assets portfolio, These are yet to be implemented. advances covered by Government guarantees, which have turned sticky, be treated as NPAs. Exclusion of such advances should be separately shown to facilitate fuller disclosure and greater transparency of operations

For banks with a high NPA portfolio, two First Asset Reconstruction Company was alternative approaches could be adopted. One established during June, 2002. approach can be that, all loan assets in the doubtful and loss categories, should be identified and their realisable value determined. These assets could be transferred to an Assets Reconstruction Company (ARC) which would issue NPA Swap Bonds
An alternative approach could be to enable the Tier II bonds are being issued by the Banks, but banks in difficulty to issue bonds which could form these are not eligible for SLR investments by part of Tier II capital, backed by government banks. guarantee to make these instruments eligible for SLR investment by banks and approved instruments by LIC, GIC and Provident Funds The interest subsidy element in credit for the priority sector should be totally eliminated andinterest rate on loans under Rs.2 lakhs should be deregulated for scheduled commercial banks as has been done in the case of Regional Rural Banks and cooperative credit institutions

(C ) Prudential Norms and Disclosure Requirements In India, income stops accruing when interest or Implemented w.e.f. year ending 31/03/2004. installment of principal is not paid within 180 days, which should be reduced to 90 days in a phased manner by 2002. Introduction of a general provision of 1 per cent on Already implemented standard assets in a phased manner be considered by RBI. As an incentive to make specific provisions, they may be made tax deductible

(D) Systems and Methods in Banks There should be an independent loan review The major banks have already implemented mechanism especially for large borrowal accounts these exposure limits. Slowly other banks are and systems to identify potential NPAs. Banks may also progressing in this field. evolve a filtering mechanism by stipulating inhouse prudential limits beyond which exposures on single/group borrowers are taken keeping in view their risk profile as revealed through credit rating and other relevant factors Banks and FIs should have a system of recruiting Banks are already recruiting specialist officers skilled manpower from the open market determined managerial remuneration levels taking into account market trends. There may be need to redefine the scope of external vigilance and investigation agencies with regard to banking business. There is need to develop information and control Risk Management, Asset Liability Management system in several areas like better tracking of and improvement in treasury have already been spreads, costs and NPSs for higher profitability, introduced in banks. accurate and timely information for strategic decision to identify and promote profitable products and customers, risk and asset-liability management; and efficient treasury management. from the open market. Public sector banks should be given flexibility to This is partially being implented

(E) Structural Issues With the conversion of activities between banks The process has already started. ICICI Ltd. Has and DFIs, the DFIs should, over a period of time converted itself into a bank by merger with convert themselves to bank. A DFI which converts ICICI Bank Ltd. to bank be given time to face in reserve equipment followed the same. in respect of its liability to bring it on par with requirement relating to commercial bank. IDBI, SIDBI too have

Mergers of Public Sector Banks should emanate Indian Banks have yet to take cue from this from the management of the banks with the recommendation and are apprehensive of the Government as the common shareholder playing a mergers. supportive role. Merger should not be seen as a means of bailing out weak banks. Mergers between strong banks/FIs would make for greater economic and commercial sense. Weak Banks' may be nurtured into healthy units by funds / borrowings etc. The minimum share of holding by These are yet to be implemented Government/Reserve Bank in the equity of the nationalised banks and the State Bank should be brought down to 33%. The RBI regulator of the monetary system should not be also the owner of a bank in view of the potential for possible conflict of interest There is a need for a reform of the deposit insurance scheme based on CAMELs ratings awarded by RBI to banks. Inter-bank call and notice money market and inter- RBI has already taken number of seps in bank term money market should be strictly this direction. restricted to banks; only exception to be made is primary dealers. Non-bank parties be provided free access to bill rediscounts, CPs, CDs, Treasury Bills, MMMF. RBI should totally withdraw from the primary market in 91 days Treasury Bills. Government is already taking steps in this

slowing down on expansion, eschewing high cost direction

RECENT HISTORY OF INDIAN BANKING

Indian banking system, over the years has gone through various phases after establishment of Reserve Bank of India in 1935 during the British rule, to function as Central Bank of the country. Earlier to creation of RBI, the central bank functions were being looked after by the Imperial Bank of India. With the 5-year plan having acquired an important place after the independence, the Govt. felt that the private banks may not extend the kind of cooperation in providing credit support, the economy may need. In 1954 the All India Rural Credit Survey Committee submitted its report recommending creation of a strong, integrated, State-sponsored, Statepartnered commercial banking institution with an effective machinery of branches spread all over the country. The recommendations of this committee led to establishment of first Public Sector Bank in the name of State Bank of India on July 01, 1955 by acquiring the substantial part of share capital by RBI, of the then Imperial Bank of India.Similarly during 1956-59, as a result of re-organisation of princely States, the associate banks came into fold of public sector banking. Another evaluation of the banking in India was undertaken during 1966 as the private banks were still not extending the required support in the form of credit disbursal, more particularly to the unorganised sector. Each leading industrial house in the country at that time was closely associated with the promotion and control of one or more banking companies. The bulk of the deposits collected, were being deployed in organised sectors of industry and trade, while the farmers, small entrepreneurs, transporters , professionals and self-employed had to depend on money lenders who used to exploit them by charging higher interest rates. In February 1966, a Scheme of Social Control was set-up whose main function was to periodically assess the demand for bank credit from various sectors of the economy to determine the priorities for grant of loans and advances so as to ensure optimum and efficient utilisation of resources. The scheme however, did not provide any remedy. Though a no. of branches were opened in rural area but the lending activities of the private banks were not oriented towards meeting the credit requirements of the priority/weaker sectors. On July 19, 1969, the Govt. promulgated Banking Companies (Acquisition and Transfer of Undertakings) Ordinance 1969 to acquire 14 bigger commercial bank with paid up capital of Rs.28.50 cr, deposits of Rs.2629 cr, loans of Rs.1813 cr and with 4134 branches accounting for 80% of advances. Subsequently in 1980, 6 more banks were nationalised which brought 91% of the deposits and 84% of the advances in Public Sector Banking. During December 1969, RBI introduced the Lead Bank Scheme on the recommendations of FK Nariman Committee. Meanwhile, during 1962 Deposit Insurance Corporation was established to provide insurance cover to the depositors.

In the post-nationalisation period, there was substantial increase in the no. of branches opened in rural/semi-urban centres bringing down the population per bank branch to 12000 appx. During 1976, RRBs were established (on the recommendations of M. Narasimham Committee report) under the sponsorship and support of public sector banks as the 3rd component of multi-agency credit system for agriculture and rural development. The Service Area Approach was introduced during 1989. While the 1970s and 1980s saw the high growth rate of branch banking net-work, the consolidation phase started in late 80s and more particularly during early 90s, with the submission of report by the Narasimham Committee on Reforms in Financial Services Sector during 1991. In these five decades since independence, banking in India has evolved through four distinct phases: Foundation phase can be considered to cover 1950s and 1960s till the nationalisation of banks in 1969. The focus during this period was to lay the foundation for a sound banking system in the country. As a result the phase witnessed the development of neces sary legislative framework for facilitating re-organisation and consolidation of the banking system, for meeting the requirement of Indian economy. A major development was transformation of Imperial Bank of India into State Bank of India in 1955 and nationalisation of 14 major private banks during 1969. Expansion phase had begun in mid-60s but gained momentum after nationalisation of banks and continued till 1984. A determined effort was made to make banking facilities available to the masses. Branch network of the banks was widened at a very fast pace covering the rural and semi-urban population, which had no access to banking hitherto. Most importantly, credit flows were guided towards the priority sectors. However this weakened the lines of supervision and affected the quality of assets of banks and pressurized their profitability and brought competitive efficiency of the system at a low ebb. Consolidation phase: The phase started in 1985 when a series of policy initiatives were taken by RBI which saw marked slowdown in the branch expansion. Attention was paid to improving house-keeping, customer service, credit management, staff productivity and profitability of banks. Measures were also taken to reduce the structural constraints that obstructed the growth of money market. Reforms phase The macro-economic crisis faced by the country in 1991 paved the way for extensive financial sector reforms which brought deregulation of interest rates, more competition, technological changes, prudential guidelines on asset classification and income recognition, capital adequacy, autonomy packages etc.

RBI tightens norms for NBFCs

The Reserve Bank of India has proposed tighter norms for non-banking financial companies with regard to capital requirements, risk weights, provisioning norms and asset classification. The central bank has proposed that stake transfer of NBFCs of more than 25% will need RBIs prior approval. In addition, NBFCs having asset size of Rs 1000 crore or more will require RBIs approval for the appointment of a chief executive officer. The central bank has released the revised draft guidelines with regard to NBFC regulation based on the recommendations of the Usha Thorat committee which was set up to review the existing regulatory and supervisory framework of such entities. For all captive NBFCs, those who are primarily engaged in financing parents companys products, tier-I capital requirement has been raised to 12% from 7.5%. NBFCs that are involved in financing to sensitive sectors like stock market, real estate and commodities, will also have to maintain 12% tier I capital. For all other NBFC, tier-I capital requirement has been hiked to 10% from 7.5%. Overall capital adequacy requirement of NBFCs have been retained at 15%. It is proposed that risk weight for NBFCs that are not sponsored by banks, should be 125% for commercial real estate exposure and 150% for capital market exposure. The central bank has also proposed asset classification norms for NBFCs should be in line with that of banks, though in a phased manner. At present, while banks classify an asset as nonperforming if repayment is due for 90 days, for NBFCs it is 180 days. It is now proposed from April 1 2014, NBFCs will classify as account as NPA if payment is overdue for 120 days and follow the 90 day norm after a year later. Further, it is proposed to raise the provisioning for standard assets from 0.25% to 0.40% of the outstanding amount from March 31, 2014 for all NBFCs, RBI said. The banking regulator has said all the deposit taking NBFC should be rated by a credit rating agency and unrated entities will not be allowed to accept public deposits. Unrated NBFCs-D has been given one year to get themselves rated if they wish to continue to accept deposits. RBI has laid revised the principal business criteria as it has made by increasing the threshold for NBFC. According to the revised norms, a company that does not accepting deposits, will qualify for registration as NBFC if and when its financial assets aggregate Rs 25 crore and constitute 75% and above of its total assets and financial income constitutes 75% or above of

its gross income. Existing NBFCs will be given a period of 2 years with the following milestones for achieving the minimum threshold of Rs. 25 crore of financial assets. The central bank also said if a group has floated multiple NBFCs but those will not be viewed on a standalone basis and instead their total assets will be aggregated to determine if such consolidation leads to the cut off limit prescribed for a systemically important NBFC that is Rs 100 crore of assets. Regarding liquidity management of NBFCs, RBI said those entities should maintain high quality liquid assets in cash, and there should not be any liquidity gap in the 1-30 day bucket.

Private Banks
Private Banks (old and new) 1 Bank of Madura 2 Bank of Punjab 3 Bank of Rajasthan 4 Bareilly Corpn Bank 5 Benaras State Bank 6 Bharat Overseas Bank 7 Catholic Syrian Bank 8 Centurion Bank 9 Development Credit Bank 10 Dhanalakshmi Bank 11 Federal Bank 12 Global Trust Bank 13 ICICI Bank 14 IDBI Bank

15 IndusInd Bank 16 J & K Bank 17 Karnataka Bank 18 Karur Vysya Bank 19 Lakshmi Vilas Bank 20 Lord Krishna Bank 21 Ratnakar Bank 22 Sanglis Bank 23 SBI Commercial & International Bank 24 South Indian Bank 25Tamilnad Mercantile Bank 26 Times Bank 27 United Western Bank 28 UTI Bank 29 Vysya Bank

Public Sector Banks

INDIAN BANKING SYSTEM Indian banking system comprises Reserve Bank of India, other apex banking institutions such as NABARD (Agriculture Financing), National Housing Bank (Housing), Export Import Bank of India (Export-Import), Commercial Banks (Public Sector Banks, Private Sector Banks, Foreign Banks) Regional Rural Banks, Co-operative Banks, Development Financial Institutions such as IDBI, ICICI, IFCI etc. and other financial intermediaries (LIC, GIC, UTI etc). A Apex Institutions: 1 Reserve Bank of India

2 National Bank for Agriculture and Rural Development 3 National Housing Bank 4 Export Import Bank of India B Commercial Banks a Public Sector Banks - 27 a SBI and associates 1 State Bank of India 2 State Bank of Hyderabad 3 State Bank of Indore 4 State Bank of Patiala 5 State Bank of Saurashtra 6 State Bank of Mysore 7 State Bank of Travancore 8 State Bank of Bikaner & Jaipur

B Nationalized Banks
1 Allahabad Bank 2 Andhra Bank 3 Bank of Baroda 4 Bank of India 5 Bank of Maharashtra 6 Corporation Bank 7 Canara Bank 8 Central Bank of India 9 Dena Bank 10 Indian Bank

11 Oriental Bank of Commerce 12 Indian Overseas Bank 13 Punjab & Sind Bank 14 Punjab National Bank* 15 Syndicate Bank 16 Union Bank of India 17 United Bank of India 18 UCO Bank 19 Vijaya Bank